Business Recordkeeping

Inventory Accounting

As we said back in our
Payables Accounting column —
"Inventory (products bought for resale,
materials bought to manufacture products to be sold,
etc., can't be expensed until sold —
and in the meantime are accounted in an inventory asset-account,
e.g., payable / amt– inventory / amt+ ".
So we got materials into the inventory account through payables.
How do we get them out?
That's the job of inventory accounting.

If you're doing just custom jobs,
where you're buying materials strictly for that job —
like a residential custom builder —
you could use a "percent completion" method.
You buy the materials to a job-number and
account your labor to the job-number —
accumulating them in an inventory account —
and then periodically expense them
according to the percent the job is complete,
inventory / amt– cost-of-sales / amt+ .
When the job is 100% complete,
all of your costs for that job have been expensed,
and no more sits in inventory.

However, if you're manufacturing a product line,
with subassemblies common to multiple products,
things aren't quite as simple.
If you walk through the plant,
you'll find stocks of purchased parts and materials,
stocks of subassemblies,
and batches of end products
being assembled and tested for scheduled shipping.

Each of these is different.
Purchased materials have no labor content —
but subassemblies do have labor content.
And the end products have both labor and subassembly content.

How do you know what dollars you have invested
in all these stocks and batches?
And how do you know how many dollars
to expense to cost-of-sales when you ship a product?

Inventory Processing

I'll lead you through a system I used back in the '70s.
It's not the only system —
nor necessarily the best.
It's just one that worked well for me.

First, you'll need inventory accounts
to reflect the inventories you have —
a purchased-materials account
to account your purchased parts and materials...
a subassembly-inventory account
to account your subassemblies...
and a product-inventory account
to account your end products.

Parts and materials get into your
purchased-materials account through payables,
payable / amt– purchased-materials / amt+ .
The purchased-materials account balance
contains the cost of all
those stocks of parts and materials
on the plant floor.

Now you purchased those materials to build things —
subassemblies and products.
Let's say we want to build 50 of some subassembly.
So we compose a Job Order to tell
the assembly people what we want to build.
And we give this Job Order a number, say S001 —
"S" for subassembly.
The assembly people pull the materials,
build the subassemblies
and return the Job Order showing
they've completed the subassemblies.

We now have that many fewer parts in stock —
and that many more subassemblies.
So we take the costs of those parts
out of our purchased-materials account
and add them into our subassembly-inventory account,
purchased-materials / amt–
subassembly-inventory / amt+ .
The subassembly-inventory account balance
now shows the material cost of those 50 subassemblies.

But those subassemblies should also
contain the cost of the labor expended
in building them.
So we have the assemblers charge their time
to the S-job number they're building.
In our Payroll processing,
we recognize that any S-job labor-expense
should be accounted to our subassembly-inventory account,
accrued-wages / amt–
subassembly-inventory / amt+ .
Our subassembly-inventory account balance
now includes the labor cost of those subassemblies.

Now let's say we want to build 25 of a product,
and that product contains 2 of the subassemblies
we just built plus some purchased materials.
So we compose a Job Order to tell
the product assembly people what we want to build.
And we give this Job Order a number, say P001 —
"P" for product.
The assembly people pull the parts and subassemblies,
build the products
and return the Job Order showing
they've completed the products.

We now have that many fewer parts and subassemblies in stock —
and that many more products.
So we take the costs of those parts
out of our purchased-materials account,
and the costs of those subassemblies
out of our subassembly-inventory account,
and add them into our product-inventory account,
purchased-materials / amt–
subassembly-inventory/amt–
product-inventory/amt+ .
The product-inventory account balance
now shows the materials cost of those 25 products.

But those products should also
contain the cost of the labor expended
in building them.
So we have the assemblers charge their time
to the P-job number they're building.
And in our Payroll processing,
we recognize that any P-job labor-expense
should be accounted to the product-inventory account,
accrued-wages / amt–
product-inventory/amt+ .
Our product-inventory account balance
now includes the labor cost of those products.

We now know what each of those products cost us to build —
1/25 of the product-inventory account balance.
When we ship one, we can account its cost-of-sales
in our Sales Journal transaction,
receivable / amt+
revenue / amt–
product-inventory / amt–
cost-of-sales / amt+ .

Now let's take a look at what these Job Orders look like.
They obviously have to contain a list of materials
so the assemblers know what parts and materials to pull.
And somewhere there have to be some instructions
on what to do with those parts and materials.
So why not combine them, e.g., like a recipe —
"pull these parts, do this with them,
then pull these parts, do this with them, etc, etc."

This "recipe", for building one (subassembly or product),
can be your engineering documentation —
it carries a subassembly or product (part) number
that you assign when you design it.
If the assemblers need a drawing to refer to,
the recipe can simply say, "refer to drawing so-and-so".
(I prefer to use a model —
built by an assembler under engineering auspices.)

Now the Job Order becomes simply a copy of that "recipe"
with the quantity changed to the number you want to build.

Inventory Ledgers

In practice, you'll have many parts and materials
flowing through this process —
into subassemblies and products into shipping —
in various stages of completion.
How do you keep track of all this stuff?
You'll need a subsidiary ledger for each of your inventory accounts —
a Purchased-Materials ledger (one sheet per part number),
a Subassembly ledger (one sheet per subassembly part number),
and a Product ledger (one sheet per product part number).

When you purchase parts,
you not only post the cost to the Payables ledger —
but you also post the quantity and cost to the Purchased-Materials ledger.

When you get an S-job back from the floor,
you post the quantity and cost of the parts used
to the Purchased-Materials ledger
(referencing the S-job number).
The totaled cost of the parts posted
is the material cost of the subassemblies —
which you then post to the Subassembly ledger.
When payroll is run,
you post the S-job labor not only to the Payroll ledger —
but also to the Subassembly ledger
(to the sheets corresponding
to the subassembly part numbers built).

When you get an P-job back from the floor,
you post the quantity and cost of the parts used
to the Purchased-Materials ledger
(referencing the P-job number),
and you post the quantity and cost of the subassemblies used
to the Subassembly ledger
(referencing the P-job number).
The totaled cost of the parts and subassemblies posted
is the cost of the products —
which you then post to the Product ledger.
When payroll is run,
you post the P-job labor not only to the Payroll ledger —
but also to the Product ledger
(to the sheets corresponding
to the product part numbers built).

And when you get shipping papers back from the floor
telling you products have shipped,
you post the quantity and cost of the products shipped
to the Product ledger
(referencing the Sales (or Shipping) Order) —
which cost is the cost-of-sales amount
posted to the Sales Journal
when you prepare and account the Customer Invoice.

As parts are purchased and used,
subassemblies built and used,
products built and shipped,
the sheets in your ledgers
tell you the current quantity and cost balance
of each of your parts, subassemblies and products.
The individual cost balances in your Purchased-Materials ledger
should total to the balance in your purchased-materials account.
Similarly, the individual cost balances in your Subassembly ledger
should total to the balance in your subassembly-inventory account,
and the individual cost balances in your Product ledger
should total to the balance in your product-inventory account,

Now this is a lot of work manually.
But it's not a big deal on computer.
If your "recipes" are on computer,
you just print them out for a new Job Order —
and if your payables and payroll are already on computer —
all the data's there for your computer
to construct and maintain these ledgers.

Standard Cost

One alternative to the above system
should be mentioned — a standard cost system.
Rather than tracking "actual" costs
through the manufacturing process,
we track "estimated" (or standard) costs
and periodically correct our inventory accounts
to reality, e.g., through inventory counts.

This avoids the inventory ledgers and multiple accounts.
Rather we estimate the material and labor cost
of each subassembly and product
and assign it that (standard) cost.
When we ship a product,
we move its standard materials cost
from our purchased-materials account —
and its standard labor cost
from our manufacturing-labor-expense account —
into our cost-of-sales account,
receivable / amt+
revenue / amt–
purchased-materials / amt–
manufacturing-labor / amt–
cost-of-sales / amt+

This system buys you simplicity —
at the cost (loss) of considerable visibility and control.
Of course, if you're not going to use that visibility
to better control your manufacturing process anyway,
then you might as well go the route of simplicity.